How Megabanks Corrupt Regulators, LIBOR Edition

July 5, 2012

If you haven’t been following that other British scandal—not Murdoch, but the interest-rate scandal that made heads roll at Barclays—then you really should be. As Matt Taibbi explains, it’s a neutron-bomb of a revelation that’s caused even hardened cynics to rethink their assumptions about the banking system. It’s as though the people who knew there was gambling going on at Rick’s Café have suddenly discovered it was also a hub for human-trafficking.

The crux of the scandal has to do with an interest rate called LIBOR—the London interbank offered rate—on which trillions of dollars of transactions across the world are based. LIBOR reflects how much it costs banks to borrow from one another and gets set every day after 16 global megabanks—among them JP Morgan and Deutsche Bank—submit reports to Thompson-Reuters, which then tallies them up and releases a kind of average figure. If you’ve taken out an adjustable-rate mortgage or a college loan recently—or, say, been a party to an interest-rate swap—there’s a good chance you’ve relied on LIBOR.

The source of the scandal is that banks like Barclays allegedly low-balled their LIBOR reports during the fall of 2008 in order to show they were healthier than they actually were. (A healthy bank can borrow at a cheaper rate than a struggling bank, all else equal.) This in itself is disturbing, since it suggests the world’s megabanks can manipulate borrowing costs for hundreds of millions of people, when we’d previously assumed these costs were largely set by market forces.

But there’s an even more disturbing twist, which is that the Bank of England appears to have had a role encouraging this manipulation, though how willful a role is still unclear. Here’s the relevant passage from today’s Wall Street Journal:

On Tuesday, Barclays … released an October 2008 email from Mr. Diamond [Barclays then-CEO] to two colleagues in which he described a phone call from the Bank of England's Mr. Tucker. According to Mr. Diamond's notes, Mr. Tucker said unidentified senior British government officials were concerned that Barclays was consistently reporting above-average Libor readings.

"Mr. Tucker stated…that while he was certain we did not need advice, that it did not always need to be the case that we appeared as high as we have recently," according to Mr. Diamond's notes. Mr. del Missier, to whom Mr. Diamond emailed his notes, interpreted them as a Bank of England instruction for Barclays to submit lower Libor readings, according to Barclays.

Basically, Barclays is saying that the Bank of England all-but explicitly advised it to lower its interest-rate reports to LIBOR, because otherwise people would get the impression that the bank was in lousy health, and that might create problems (via some kind of run). According to the Journal, Barclays went along with this partly because it felt that a lot of unhealthy banks were already submitting implausibly low reports, so it would be foolish to hold out.

The whole smelly mess raises a variety of uncomfortable questions. (For example: If other megabanks were cooking their submissions, as is currently being investigated, were they getting similar nudges from their own central banks—like the Federal Reserve in this country?) But the biggest question is the most fundamental one: Is it even possible to regulate megabanks in any meaningful sense? After all, if the allegations are true, officials at the Bank of England weren’t sending these hints to Barclays because they took a shine to Barclays’ executives or because they stood to benefit personally if the bank’s share-price rose. They were doing it because they worried that a run on a bank as big as Barclays would destabilize the British economy and wanted to do everything possible to avoid that, even if it meant skirting the rules (again, according to the allegations).

Which is to say, in order to get corruption in your banking system, you don’t need literal corruption of the Government Official X owns shares in Bank Y variety (or even Official X wants to work at Bank Y after he leaves government). You just need banks big enough so that the bureaucrats keeping an eye on them have nightmares about what happens if the banks fail. At that point the bureaucrats will dedicate themselves to keeping the megabanks afloat at all costs, even it requires methods that aren’t on the up and up.

And it’s worth pointing out that Britain, of all countries, should be relatively less susceptible to this, since its central bank (the Bank of England) doesn’t even technically regulate its biggest banks. (That honor falls to the independent Financial Services Authority.) In the United States, on the other hand, the Fed has a lot of responsibility for monitoring megabanks. After the LIBOR scandal—to say nothing of that whole financial crisis and bailout thing—can anyone honestly say they don’t have questions about whether Fed officials may be tempted to bend the rules for megabanks, even if their intentions are entirely pure?